Italy risks reigniting the eurozone crisis

Another eurosceptic and indebted country is testing Brussels’s power over the eurozone project.

DEC 2018
Michael Collins
Investment Specialist

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December 2018

Italy’s corruption scandals of 1992 to 1994 that ended its First Republic gave life to the Lega Nord political party that was founded in 1989 to create a breakaway region called ‘Padania’ in Italy’s north.[1] A favourite target of the Northern League party that at 1994 elections[2] helped Silvio Berlusconi become prime minister for the first of three times was the Italian flag – its founder Umberto Bossi received a 16-month suspended sentence for the crime of ‘insults against the flag’. Other foils were immigrants, southerners, globalisation and Europeanisation, especially the euro, which Italy only could adopt after fudging its finances. Public debt reached 100% of GDP,[3] which was well beyond EU limits, the year before the corruption scandal erupted[4]

In the early 2000s, Italian comedian Beppe Grillo used to smash computers to end his performances to show the nothingness of the internet. He soon realised the web was good for something. From 2005, Grillo wrote a weekly political blog read by millions. From that momentum, Grillo in 2009 founded the anti-establishment Movimento 5 Stelle that looked to southern Italy for support. From 2012, the Five Star Movement’s popularity soared so much that at the 2013 national elections only votes from abroad stopped Five Star from becoming parliament’s biggest party.[5]

Over the next five years, Five Star and the League under Matteo Salvini broadened their countrywide appeal (thus the shortening of the Northern League’s name in 2017). Such was their success at the elections in March this year that two months later the pair formed an unlikely coalition that became the first eurosceptic government to take charge of one of the six founding members of the EU. (So intense was the haggling between such disparate parties that someone belonging to neither coalition partner was appointed prime minister, namely Giuseppe Conte. He became Italy’s fifth consecutive unelected leader.)

A core promise of Salvini and Grillo, who can have no parliamentary role due to a conviction of death by dangerous driving in 1988, was they would blast Italy out of two decades of economic stagnation. Italy’s real GDP per capita is still below the levels of 1999 when the euro was launched, whereas Germany’s has grown 27% over that time.[6] Government debt now stands at 133% of GDP,[7] the highest in the eurozone after Greece, as the government’s interest bill each year (that, at 4% of GDP, roughly equals that of education spending)[8] turns what would be a budget surplus into a deficit.[9] The country has a banking sector riddled with bad loans, has suffered double-digit unemployment rates since 2012,[10] and watches its young and educated emigrate every year.

Among the first tasks of the League-Five Star government was the need to form a budget for 2019 that revives economic growth. Rome chose to push for a budget that breaks the Brussels guidelines for indebted governments, a stance that risks placing Italy at the centre of a renewed eurozone debt crisis.

Italy comes to a showdown with the EU with the belief that as a country of 60 million people and the eurozone’s third-largest economy it is too powerful to be bullied and too big to be allowed to collapse. Rome knows that Brussels has no legal means to enforce the will of the creditor nations who favour austerity – the EU’s primary threat is financial penalties. Rome grasps too that its net contributions to the EU budget and past threats to introduce a parallel currency to ease Italy from the euro bolster its negotiating power.

Rome’s biggest menace is the financial enemy Italians dub ‘lo spread’. This is their name for the higher yield investors demand to hold Italian government debt over their German equivalents – the spread on Italian 10-year sovereign bonds over German bunds has risen from about 135 basis points in March to 290 basis points on November 30. If the gap widens too much, the associated rise in interest rates and tightening in the availability of credit could impede Italy’s economy, possibly to the point of recession. In extremis, higher Italian bond yields could trigger the ‘doom loop’. This is the process whereby declines in the value of Italian government bonds erode the capital buffers of Italian banks that hold much of Rome’s debt, and Italy’s banking system could be vulnerable. A less-visible and perhaps unlikely complication are depositors at Italian banks. If they were to lose confidence and shift their euros outside the country, Italy’s banking system would be vulnerable in a different way. As any crisis emerged, it is likely the EU’s tactics would be to hope the spread overwhelms Rome’s resolve. If so, the crisis would be quickly quelled.

The risk for the contagion-prone eurozone, however, is that the Rome-Brussels battle is broader than just finances – it’s part of a fight over the national power within the EU. Politics thus demand both sides confront each other – Italy’s new government needs to prove its credibility while the EU must uphold the rigour of its budget rules. Of little comfort during any showdown is that Europe’s rescue mechanisms appear inadequate to cope should Italy expose that the eurozone’s design flaws are still unaddressed. While the pressure on both sides to compromise will likely resolve these disputes in time to limit damage, Italy is likely to trigger a series of crises for the eurozone that will call into question the euro’s durability.

It must be said that no one is intent on taking Italy out of the euro. All sides know that only mayhem would be triggered by any exodus from a currency union that brooks no departure because member finances are so interlocked. The economic damage a rising spread might do to Italy means that Rome would be under immense pressure to yield while questions about Italy’s euro membership give Brussels an incentive to compromise.[11] That a resolution is the most likely outcome explains why there’s no sign yet of the contagion spreading beyond Italy. The spread might stay at acceptable levels anyway – Italy’s current-account surplus helps in this. A bigger longer-term worry though is that the budget fight is probably over nothing. Any fiscal stimulus, even if it doesn’t backfire by boosting interest rates, is unlikely to rejuvenate an economy that, while a manufacturing force, is burdened by red tape, low productivity and a poor education system.

The wider truth is that Italy’s new rulers have assumed control of the eurozone’s vulnerable point that will need years of micro-economic reform to be made competitive. The country’s economy is so fragile a recession could damage Rome’s finances and Italian banks to the point of crisis. A stagnant and indebted Italy is likely to prove an enduring source of instability within a flawed currency system for the foreseeable future – but not an existential threat.

Murky modelling

The middle weeks of March 1983 are judged the “most critical” of François Mitterrand’s two terms as French president (1981-1995) by his regarded English-language biographer, Philip Short.[12] The background is that the socialist program Mitterrand launched on taking power damaged government finances and prolonged double-digit inflation.[13] He quickly had to introduce austerity and devalue the franc twice within the European Monetary System. Under this scheme, European currencies fluctuated tightly against each other – which forced joint government action at times to preserve the system – while they jointly floated against the US dollar.

Socialist losses at municipal elections in March 1983 due to high unemployment forced a choice on Mitterrand. Option one was to withdraw the franc from the currency system and let its value be market set. That would leave Mitterrand free to revive the economy. The other was to double down on austerity and devalue the franc for a third time. The wider political decision was the future of France’s quest to drive European integration.

On Monday March 14, Mitterrand decided to float the franc. But by the following Sunday at an emergency meeting of European finance ministers, Mitterrand kept France in the currency system, accepted an 8% devaluation and agreed to intensify austerity. Sometime over those seven days, Mitterrand chose Europe. Historians speculate that if he had floated the franc Europe’s integration that led to the euro would never have eventuated.

Whatever the conjecture, what’s clear is Mitterrand had choices in 1983. Yet the monetary system he helped create gives policymakers little or no choice. League-Five Star can’t quit the euro so it has no currency to let slide – a common ploy of lira-era Italian governments. Rome has no monetary policy to loosen (though the European Central Bank’s monetary policy is lax by any standard). Rome’s only macro lever is fiscal policy. But under EU policies to protect the European monetary system and taxpayers from rogue countries, Rome can barely turn to fiscal stimulus.

That became obvious on October 24 when the European Commission took a drastic step for the first time. The EU’s executive arm rejected Italy’s draft budget for 2019 because Rome is “going against the commitments” made in April by the previous government and is in breach of EU budget diktats. Under the terms of euro membership set by the Maastricht Treaty of 1992 that were hardened into EU law in 2013, budget deficits are restricted to 3% of GDP and government debt limited to 60% of output.[14]

The complication is that Italy’s draft budget only proposed a deficit of 2.4% of GDP for 2019, even if the shortfall was three times higher than the former’s government’s projection. But debt-reduction rules that apply to indebted governments and a change in the way the EC measures budget deficits cloud the process. In 2011, Brussels moved from numerical deficit targets to focus on a country’s ‘structural budget balance’.[15] This measure excludes acceptable one-off spending and allows for shifts in public spending and revenue tied to economic growth. Experts say the new formula is “deeply misleading” and “rests on guesswork”.[16]

Under the new method, the EC estimates Italy’s expected growth rates, the country’s ‘output gap’ and ‘non-accelerating wage rate of unemployment’ and other variables. The Brussels modelling demanded Rome reduce its ‘structural deficit’ to 0.6% of GDP for 2019 to help reduce government debt. Rome, which assumes different key estimates in its analysis (and some are rubbished by Italy’s nonpartisan budget-watching body)[17] sought to lift its structural deficit by 0.8% of output to reignite Italy’s economy, which stalled in the third quarter.

On such disputed econometrics hang financial penalties if Rome insists on breaching EU budget edicts, the political credibility of League-Five Star coalition and the standing of the EU’s budget oversight. So too rests ’lo spread’, the interest rates that influence Italy’s economic growth, and timing and duration of any eurozone debt crisis centred on Italy..

Hobbled help

The most famous phrase of the eurozone crisis is ECB President Mario Draghi’s pledge in 2011 to “do whatever it takes” to save the euro. But they were just words, even if they bewitched investors. The ECB needed a framework to show that a stateless central bank could defend a stateless currency. So the central bank in 2012 devised the ‘Outright Monetary Transactions’ program, whereby conditions were set under which it can endlessly buy distressed sovereign debt.[18]

Draghi’s scheme strove to overcome restrictions that stopped the ECB acting as a ‘lender of last resort’, which means providing unlimited money for governments and banks. It is under this program that Draghi in October said the ECB would protect the euro in the event of any Italian crisis.[19] The problem is that the untested program contains conditions that neuter its effectiveness. (A further complication is that parliaments including Germany’s need to approve the scheme’s implementation.[20])

For the likely setting of any Italian crisis, Draghi’s scheme presents a Catch-22. This is that the ECB’s emergency support can only be enacted if a government agrees to implement austerity and free-market reforms.[21] Yet Italy would only trigger the need for the scheme if Rome and Brussels were at an impasse.

The danger for Italian banks is that any crisis could create a downward spiral while reducing their ECB protection. If higher bond spreads prompt rating companies to downgrade Italy’s sovereign debt rating, the ECB can’t accept these bonds as collateral under its ‘targeted long-term repurchase operations’ that offers banks money for up to four years. Rome’s debt is one notch above this humiliation with Moody’s Investors Service and only two notches higher with Fitch Ratings and Standard & Poor’s.[22] A separate handicap for any crisis in Italy are EU rules that forbid governments rescuing banks – a ban Rome says it would ignore.

Policymakers could ease these restrictions in negotiations, which means the budget issue feeds into the wider political battle between League-Five Star and the EU.

But it’s likely a showdown between Rome and Brussels looms. Lo spread will decide the timing and grade of the budget crisis. It will likely put such pressure on Rome that it backs down. At the same time, the threat to the euro could help force Brussels to strengthen the eurozone’s defences – say, by pushing for more fiscal integration for starters. The most optimistic view to take as the debt left by the crooked lawmakers of Italy’s First Republic rumbles through the Second Republic is that policymakers might take steps that prove as transformative for Italy and the eurozone as the corruption crisis of the 1990s proved to be for Italy’s political system.

By Michael Collins, Investment Specialist

Lo spread. Yield of Italian 10-year government bonds over German equivalent over 2018

Source: Datastream

[1] Lega Nord was formed when several leagues in the northern regions of Lombardy and Veneto meshed. Most of the time the League stands for greater power for regions under a federalist system. At times it has sought secession.

[2] These elections were held under the Second Republic’s design. The Second Republic is considered to have started when a referendum in 1993 approved a mixed voting system known as the Mattarellum where 75% of candidates were elected in first-past-the-post electorates. The Mattarellum replaced the proportional representational system of the First Republic that began in 1946 when Italians chose between a republic or a monarch in a referendum.

[3] International Monetary Fund. World Economic Outlook database. October 2018. ‘General government gross debt. Percent of GDP.’ Italy’s ratio reached 102% in 1991, having hit 99% the previous year. Italy’s net government debt reached 102% of GDP in 1992, having stood at 95% in 1991.

[4] John Foot. ‘The archipelago. Italy since 1945.’ Bloomsbury Publishing.’ 2018. Page 276. More broadly, Chapter 5. The Second Republic. Pages 271 to 348. Bossi’s sentence was later reduced to a small fine.

[9] Since 1992 Rome has posted a surplus before interest payments (a feat known as a primary budget surplus) in every year but 2009 and 2010. See IMF op cit. ‘General government primary net lending/borrowing. Percent of GDP’.

[11] See opinion piece by David Folkerts-Landau, chief economist at Deutsche Bank in The Financial Times. ‘Europe must cut a grand bargain with Italy.’ 12 November 2018. ft.com/content/a8d572b8-e65d-11e8-8827-ff56e7163c11?segmentId=6132a895-e068-7ddc-4cec-a1abfa5c8378. He suggests Italy’s interest payments could be reduced.

[18] The ECB said when announcing the scheme that “no ex ante quantitative limits are set on the size of Outright Monetary Transactions”. ECB “Press release. 6 September 2012 – Technical features of Outright Monetary Transactions.” ecb.com

[20] See the media release from Germany’s Federal Constitutional Court. ‘Constitutional complaints and Organsteit proceedings against the OMT program of the European Central Bank unsuccessful.’ 21 June 2016. bundesverfassungsgericht.de/SharedDocs/Pressemitteilungen/EN/2016/bvg16-034.html. It judged the program does not “impair the Bundestag’s overall budget responsibility”.

[21] A country must have sought help from Europe’s rescue fund, the European Stability Mechanism, to be eligible for the Outright Monetary Transactions program.

[22] Moody’s rates Rome’s debt ‘Baa3’, the lowest ‘investment grade’ rating. Standard & Poor’s and Fitch Ratings rate Rome’s debt at BBB but on negative outlook. If Italy’s bonds were rated junk the ECB wouldn’t be able to buy them under its quantitative-easing program but that’s ending in December anyway.

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